Trading The Fiscal Cliff

It was perfectly predictable! As soon as the election was over, all the media
coverage would be on the US Fiscal Cliff. Why it wasn't even raised by either
party during the election campaigns or dragged into the coverage by the media
is another discussion. The same reasons it was put off untill after the election,
not discussed during the election, are the same excuses that make how it will
be resolved, also perfectly predictable.

Both parties will reach an agreement to effectively "Kick the Can Down the
Road". Yes, there will be some compromises to give the impression of serious
deliberations, but nothing more than 'headlines' for the media and the semi
interested public. The soon to be heralded compromises such as not increasing
taxes for the rich and not cutting entitlement programs for the growing masses
of Americans dependent on transfer payments will be justified by vague reference
to closing tax loop holes, agreeing to bipartisan studies on entitlements and
closer cooperation. Translation: Do Nothing!

The problem that most have been carefully distracted from, is why the Fiscal
Cliff was crafted in the first place. Some will recall the earlier crisis,
that without immediate and dramatic financial actions by congress, the US was
about to have its credit rating lowered significantly by the credit rating
agencies. The politicos were forced to craft these commitments, to buy time
and yet not be responsible for the unpopular actions prior to an election.
Lower credit rating have traditionally meant higher cost of government financing.
Often the death blow to a bloated deficit ridden economy.

So it actually isn't about the Fiscal Cliff, since we already know the outcome.
The issue is an almost guaranteed lowering of the US Credit Rating.

What needs to be fully appreciated is that the US dollar as the world's reserve
currency is based on it being considered RISK-FREE. As a matter of standard
financial practice, all financial risk is assessed and priced off of the spreads
against the risk free US Treasury instruments.

Clearly the US$ and US Treasuries are no longer RISK FREE. The fact that the
Fiscal Cliff will be 'kicked down the road' without serious changes to protect
investors and the risk free status of US government securities, is an official
acknowledgement that the US has no intentions of seriously living up to the
both the burden and responsibility and of being the global reserve currency.

What effectively is occurring is the US is becoming a counterfeiter of RISK
FREE ASSETS and expecting the rest of the world to accept them and price assets
based on them.

What is a Trader To Do?

It is important for traders to appreciate the significance of this. It means
that the equity risk premium used for valuations is no longer valid. The long
accepted "Fed Valuation Model" has broken down.

The market, as a forward looking entity, has already began to price this into
stock prices. PE ratios are now compressing after having been artificially
expanded due to the expectations of QE III and further central bank liquidity
expansion.

To clearly show what is happening we first need to consider how investment
regimes as defined by the PE Ratio have behaved since the mid-1960s. Below
is a representative study by UBS.

The Disco Regime (1965-80). During the 70s, inflation was the
key driver of stock multiples, given that prices were not only rising sharply,
but also in a volatile manner.

In the 1970s, inflation was the primary driver of stock valuations...

Falling inflation since the late '70s has made CPI less important to valuations...

The Great Moderation (1981-99). After Chairman Volker broke
inflation, the economy entered an 18-year period of solid, less volatile growth,
accompanied by falling interest rates. In this environment, investors could
focus on a nominal cost of capital (the Fed model) to value stocks.

During the "Great Moderation", the "Fed Model" explained returns...

Since 2000, the Fed Model has broken down...

The Hangover Regime (2004-09). In the aftermath of the TMT bubble,
risk became a much more important driver of multiples, with investors using
a full cost of capital to value stocks. During this period, stock multiples
were closely tethered to investment grade (Baa) yields.

Hangover Part II (2010-12). Over the past two years, the key
metric for valuing stocks has shifted from investment grade to non-investment
grade yields.

Given the fiscal situation in both the U.S. and Europe, this regime will likely
persist until structural imbalances are meaningfully addressed by policymakers.
Don't hold your breath on that happening without a full blown crisis.

The fact that valuations are now following those of Non-Investment grade credit
is a sign of serious problems ahead.

Progression To High Yield (HY)

Much is made of the 'apparent' bubble in Treasury bonds - a 30-year or so
relatively consistent trend in government bonds (through thick and thin)
and yet allocations remain minimal
compared to our increasingly similar Japanese friends have experienced.
It would seem to us, thanks to Bernanke's 'visible' hand that the real bubble
is in spread product - as rates are so compressed, investors seemingly oblivious
to the word 'risk' (unintended consequence) have flooded into ever-increasing
yield/spread products - with high-yield bonds now dominated by these technical
inflows (as we
noted in the close today). If ever the combination of anchoring bias,
'dance while the music is playing', and herding was evident, it is in corporate
credit. To wit, the total disengagement from reality (both real 'micro'
earnings and 'macro' economic uncertainty) that a flood of money has created
in this increasingly crowded (and increasingly illiquid) market. Managers
are well aware that the liquidity tsunami has moved the maturity mountain
(as Citi's Matt King notes) but has helped the weeds as well as the roses.

But it has reached epic proportions of disconnection in recent quarters
as 'micro' earnings have missed expectations (inverted on scale below - presented
as distance from pre-season

expectations we have had 5 quarters in a row of misses) but spreads continue
to compress...

and given the massive (almost unprecedented) levels of 'macro' policy uncertainty,
the flow of safe-haven-but-yield-chasing cash has broken the link between
the reality of risk and the pricing of risk...

and has therefore removed signaling-effects from this critical market. More
importantly, the wall of liquidity that has been squeezed into a relatively
small market has lifted all boats and enabled the entire maturity structure
of corporate debt to be kicked down the road - unfortunately enabling the
dead to live 'unproductively' far longer than they ever should - necessarily
dragging mal-investment in at every turn...

So this leaves corporate bond managers 'dancing while the music plays' yet
fully aware that the market simply cannot bear the type of exit that will occur
should reality ever seep back into the market's pricing (say by a fiscal shock?). As
Dory would say "Just keep swimming..." as Bernanke has interfered with
nature...

The markets are sending a clear signal to Washington that something of real
substance must soon occur as risk is being completely mispriced as easy money
flows to anything resembling yield and the unintended consequences of this.

Trailing PE: Shorter Term

Some outright hucksters still use the trick
of comparing current P/E's based on "forecast" "operating" earnings with
historical average P/E's based on total trailing earnings.

There is an unquestioned hope in central bank liquidity injections boasting
the markets. Expectations are that earnings will still be OK and PEs will consequently
expand further. The thinking on the street is that though Q3 earnings will
likely be minus 1.9%, and Q4 earnings is being brought down from 15% to 10.2%,
it still gives a 4.0% growth for 2012. That is higher than real GDP growth
and suggests to them, PE's will expand, especially with the 2013 forecast at
11.8%. To some analysts it is a time to remain bullish. Unfortunately all that
is priced in, along with a resolution to the year beginning US Fiscal Cliff.
What is not priced in is the magnitude of the global slowdown, which simply
won't allow for further PE expansion.

The PE Compression Shell Game

PE's are above average but trending lower. This is a sign of a Bear Market.

This Trend has been in place since 2000 when we believe the secular bear market,
if viewed in real terms, began.

Secular Bear Markets have Cyclical Bull markets within them which are not
only evident by rising stock prices but also by rising PE ratios.

If stock prices rise and earnings lag then the PE signals that stocks are
expensive relative to their earning power and other yields.

As simple as this sounds, it isn't! One reason is PE ratios can be calculated
MANY different ways to prove any number of inconsistent views of valuations.

When PE's for example are 20, it means the for every dollar a stock earns
it costs you 20 dollars to buy those earning capabilities. The yield therefore
being 1/20 or 5%

The rule of 20 has been a good rule for stocks because bond yields as a competing
asset class have approximated those yields over time. Therefore money would
flow from the stock market to the bond market and vice versa.

The Rule of 20

The rule of 20 is based on the old rule of 18-22 that said a fair valuation
PE multiple range for the market could be calculated by subtracting the expected
inflation rate from 18 and 22 to come up with this PE range. Simplified,
the rule of 20 takes the mid value between 18 and 22 (20) and subtracts the
yield on the 10 year T-Note. The yield on the 10 year treasury is 2/3 to
3/4 determined by the market's expectations for inflation, making this a
historically good proxy for inflation. The resulting plot serves as a valuation
floor for the market. Over the last 25+ years, the forward PE on the market
has closely tracked this plot and rarely trades below this multiple. Those
instances that it has traded very far above this Rule of 20 multiple have
proven to be good indications that the market was overvalued.

Fed Model

But what happens when competing yields from the bond market are held artificially
low, for protracted periods and are then ASSURED to stay low for a SPECIFIC
period of time, by the Federal Reserve?

Things then get interesting. They also get confusing, and with confusion we
get mispricing of risk.

Remember, the Federal Reserve in its desperate attempt to restart the economy
is trying to ensure asset prices remain elevated, as a fall in collateral values
is a dangerous thing when deleveraging and deflation is a prime threat within
a secular bear market.

Historically High Earnings: Peak Earnings?

You can only lay off workers for profit for so long!

Historically High PE: Peak PE?

There is little doubt that asset prices have responded to Central Bank promises
and actions. Even as bottom-up fundamentals are fading, top-down index 'nominal
prices' rise on the back of magical multiple expansion - which is defended
from on high by sell-side strategists the world over on the back of 'recovery'
is just around the corner. The trouble is there's a limit and it seems -
from QE2 and LTRO - that we are rapidly approaching that limit; and with
earnings outlooks being revised lower, perhaps we are at peak P/E for this
cycle of QE?

Each line is the normalized gain in P/E from the onset of expectations for
Central Bank largesse: (QE2 - green; LTRO - red; QEtc. - Orange).

Forcing Investors to Take on 'Mispriced' Risk

Why aren't such strong earnings growth being reflected in the 60/40?

Conclusion

The Monetary Mavens are manipulating markets metrics in such a fashion
as to intentionally Misprice, Misrepresent & Hide RISK.

Never has the game of forward operating earnings (versus historically trailing
earnings) been more inappropriate than presently. Forward PE's can only be
of value in rapid revenue and profit growth eras. This is not what we have
presently. It is the wrong tool for the wrong job! Unless you are a sell side
analyst, then it is exactly the right too for the difficult selling job you
have.

We have an era of Peak earnings growth RATES, slowing profit growth RATES,
Peak PEs which are reflective of rapidly contracting PE's.

We have a secular bear market in REAL terms but PE's are not contracting at
a sufficient enough rate to reflect this. Though PEs in nominal terms net out
inflation, they don't reflect the underlying downward trend in real terms.

The equity premium is significantly distorted as in fact the US Treasury is
NO LONGER AAA "risk free". In the Macro Analytic section of our web site I
discuss the Triffin Paradox specifically.

"To supply the world's risk-free asset, the center country must run a
current account deficit and in doing so become ever more indebted to foreigners,
until the risk-free asset that it issues ceases to be risk free.
Precisely because the world is happy to have a dependable asset to hold
as a store of value, it will buy so much of that asset that its issuer
will become unsustainably burdened."

Gordon T. Long has been publically offering his financial and economic writing
since 2010, following a career internationally in technology, senior management & investment
finance. He brings a unique perspective to macroeconomic analysis because
of his broad background, which is not typically found or available to the
public.

Mr. Long was a senior group executive with IBM and Motorola for over 20 years.
Earlier in his career he was involved in Sales, Marketing & Service of
computing and network communications solutions across an extensive array of
industries. He subsequently held senior positions, which included: VP & General
Manager, Four Phase (Canada); Vice President Operations, Motorola (MISL -
Canada); Vice President Engineering & Officer, Motorola (Codex - USA).

After a career with Fortune 500 corporations, he became a senior officer of
Cambex, a highly successful high tech start-up and public company (Nasdaq:
CBEX), where he spearheaded global expansion as Executive VP & General
Manager.

In 1995, he founded the LCM Groupe in Paris, France to specialize in the rapidly
emerging Internet Venture Capital and Private Equity industry. A focus in
the technology research field of Chaos Theory and Mandelbrot Generators lead
in the early 2000's to the development of advanced Technical Analysis and
Market Analytics platforms. The LCM Groupe is a recognized source for the
most advanced technical analysis techniques employed in market trading pattern
recognition.

Mr. Long presently resides in Boston, Massachusetts, continuing the expansion
of the LCM Groupe's International Private Equity opportunities in addition
to their core financial market trading platforms expertise. GordonTLong.com
is a wholly owned operating unit of the LCM Groupe.

Gordon T. Long is a graduate Engineer, University of Waterloo (Canada) in
Thermodynamics-Fluid Mechanics (Aerodynamics). On graduation from an intensive
5 year specialized Co-operative Engineering program he pursued graduate business
studies at the prestigious Ivy Business School, University of Western Ontario
(Canada) on a Northern & Central Gas Corporation Scholarship. He was subsequently
selected to attend advanced one year training with the IBM Corporation in
New York prior to starting his career with IBM.

Gordon T Long is not a registered advisor and does not give investment advice.
His comments are an expression of opinion only and should not be construed
in any manner whatsoever as recommendations to buy or sell a stock, option,
future, bond, commodity or any other financial instrument at any time. While
he believes his statements to be true, they always depend on the reliability
of his own credible sources. Of course, he recommends that you consult with
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